Post-Apocalypse Hedge-Fund Strategies

THE PAST FEW YEARS HAVE BEEN ROUGH on hedge funds. Even firms with billions under management and reputations to match have seen returns go south as fast as -- or faster than -- the markets. Investors might understandably ask what the "hedge" in "hedge fund" refers to.

As a result, this may not seem like the best time to pitch a start-up hedge fund to bruised investors and put money to work in nervous markets. But some people are hard to discourage. Barron's spoke with three managers, each running his own fund for the first time. Although all three have posted market-beating returns over their short histories, they all acknowledge that raising money is a long, slow process these days.

The managers agree on three broad ideas that hedge-fund operators (and their investors) should keep in mind: They should stick to the areas they know best, they need rigorous and systematic risk controls, and they should recognize that the credit crisis isn't over.

BRETT HENDRICKSON STARTED Dallas's Nokomis Capital, a long-short equity fund, in March 2008. He knew he would face what he calls the "chicken-and-egg problem." Starting with $4.2 million in capital, and having grown to $34 million including two managed accounts, "we have a number of people interested in us who say that they are looking to invest in us when our AUM [assets under management] gets bigger." But it is hard to get bigger quickly without those same investors getting on board.

For Hendrickson, risk control is a matter of both fund structure and stock selection. His portfolio generally has about 25 long positions and about 25 short, though on a dollar basis he stays around 30% net long. At the core of his holdings are eight to 12 "workhorse" names, including Hornbeck Offshore (HOS). The company has invested heavily in a fleet of offshore supply ships, which serve the oil and gas industry. Day rates for such ships have been low, but if they ramp up -- as Hendrickson believes they will -- the company's free-cash-flow yield on the current stock price could rise to 20%.

Although just 33 years old, Hendrickson has covered many of his core names for a decade, during a career on both the buy and sell sides that started in 1998, the year he graduated from Pepperdine University.

These positions tend to be "hairy" companies that don't fit neatly into a traditional sector, or face issues that take a lot of time and legwork to understand. One such company that Hendrickson likes now is Rambus (RMBS). The memory-technology licensing firm is stuck in a long legal dispute over whether the big chip makers have used its technology without paying up.

After reading thousands of pages of legal documents, Hendrickson sees big upside and enough support to limit downside in the stock. "We started buying the stock at 21, were still buying at 5, and it's at 16 now. We think the stock could go to 40 given what they are owed in royalties and settlements. Even if there are further legal delays, we think their low-power/high-bandwidth chip technology will see adoption [by smartphone makers] next year," justifying the current price. And a legal loss would, if nothing else, cut the company's big legal bills.

He also likes the potential of Deckers Outdoor (DECK), maker of UGG-brand footwear. Hendrickson's research shows that demand for its boots is holding up, despite concern that they are too pricey for the current economic environment.

Hendrickson's investors are enjoying the fruits of his labors. The fund was up 38% as of September's end, and 28% since its start in early 2008.